A Stock Market on the Edge

Our computer models have been forecasting the likely development of a long-term top in the stock market since early this year. The potential reversal formation that began to take shape in late 2009 exhibits many compelling bearish characteristics, and it is now on the verge of a meaningful breakdown.

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The S&P 500 index closed slightly lower this week, continuing a test of critical congestion support in the 1,060 area. A subsequent weekly close well below that level would be a major bearish signal indicating that a move down to new long-term lows has become highly likely. Further supporting the bearish outlook is the recent turn in the intermediate-term cycle that began in early July.

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The current cycle is only 8 weeks old, but the breakdown in early August suggests that the high of the cycle has already occurred, providing additional evidence that a new cyclical downtrend is in progress. A return to the July low sometime over the next several weeks would confirm the early August reversal of the current cycle and project a subsequent move down to new long-term lows.

The short-term picture also supports the bearish scenario as market behavior following the peak in late April has exhibited prototypical characteristics of a primary downtrend attempting to reassert itself.

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The sharp declines of the correction during May and June were accompanied by above average volume, while the oversold reactions occurred on low volume, indicating a lack of conviction on the buy side. Additionally, the rally off of the early July short-term cycle low took the form of a bearish rising wedge, and it was followed by a typically violent correction that returned the S&P 500 index to congestion support in the 1,050 area on the daily chart.

While both long-term and short-term chart analysis suggest that a new cyclical downtrend has begun, there is a confluence of fundamental developments that support the bearish case as well. In June, we observed that four recession indicators with impressive track records had all signaled that a return to economic contraction was likely during the second half of 2010.

1.The 13-week annualized rate of change of the Economic Cycle Research Institute (ECRI) Weekly Leading Indicator (WLI) analyzed by Chad Starliper of Rather & Kittrell. Every time the rate of change has fallen this sharply over the past 30 years, the economy was either already in a recession or about to enter into one.

Widening credit spreads: An increase over the past 6 months in either the spread between commercial paper and 3-month Treasury yields, or between the Dow Corporate Bond Index yield and 10-year Treasury yields.

Moderate or flat yield curve: A yield spread between the 10-year Treasury yield and the 3-month Treasury yield of anything less than 3.1%.

Falling stock prices: S&P 500 below its level of 6 months earlier. This is not terribly unusual by itself, which is why people say that market declines have called 11 of the past 6 recessions, but falling stock prices are very important as part of the broader syndrome.

Moderating ISM and employment growth: Manufacturing PMI (at or) below 54, coupled with either total nonfarm employment growth below 1.3% over the preceding year, or an unemployment rate up 0.4% or more from its 12-month low. A PMI value below 54 is currently the only criterion that has yet to be observed, although regional surveys suggest the index will likely drop into the low 50s next week.

3.The sharp contraction in broad money supply (M3) tracked by economist John Williams. Williams has noted that a massive decline such as this one has always been followed by meaningful weakness in the broad economy, and the graph below displays the historic nature of the current decline.

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4.The long-term sell signal generated by our Cyclical Trend Score (CTS). The CTS analyzes a broad set of fundamental, technical, psychological and market internal data, searching for highly likely inflection points in the stock market cyclical trend. It has only issued 13 confirmed sell signals over the past 70 years, so it does not signal very often, but generated signals tend to be very reliable as a result of its highly discriminating screening process.

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These four recession indicators have issued no false signals over the past 40 years. Additionally, this is the first time on record that all four of them have issued signals at the same time. When you couple those facts with the bearish character of stock market behavior following the peak in late April, a compelling case is made for the long-term breakdown scenario. It will be important to monitor stocks closely over the next few weeks as the market is on the verge of that breakdown right now and a weekly close well below 1,060 would be a major bearish signal.